Feb 9, 2015

NEWS: Award-Winning Research Explains Perplexing Investor Behavior

By Dimitris Papanikolaou

Why are investors so keen to invest in growth firms like Uber or Facebook—growth firms that seem risky yet have historically produced low average returns—when, say, value stocks like General Electric seem like such an attractive bet?

In new research, Dimitris Papanikolaou, an associate professor of finance at the Kellogg School, investigates. His research recently won the Amundi Smith Breeden Award for best paper in the top-ranked Journal of Finance. (Papanikolaou, who also won the award last year, coauthored this year’s paper with Leonid Kogan of MIT.)

Eighty years of stock market data suggest that “value firms” like General Electric, McDonald’s, and Procter & Gamble—firms whose market value is largely a reflection of their existing operations—perform better than “growth firms” like Uber and Facebook—companies whose value comes mostly from their potential to grow in the future, rather than from their current assets.

Growth firms are riskier bets: their potential hasn’t been realized yet, and there is no guarantee that it ever will. Plus, explains Papanikolaou, “their returns seem to be, if anything, more cyclical. They’re simply much more correlated with the market’s fortunes than, let’s say, Coca-Cola.”

Thus, you might expect growth firms to be relatively “cheaper” than value firms, in the sense that investors would demand higher returns to offset the greater risk associated with these companies. You would, however, be wrong. To the longstanding puzzlement of economists, investors actually require higher returns from value firms.

Over the years, says Papanikolaou, a number of rationales have been proposed for this perplexing investor behavior: that perhaps investors are just getting swept up in the Next Big Thing, for instance, or otherwise “making mistakes.” But Papanikolaou and Kogan have proposed an alternative explanation: that investors have a perfectly sensible reason for preferring to invest in growth companies.

Namely, the researchers believe that there is another kind of risk at play. “Value firms are riskier in the sense that they have more chance of being displaced by new technologies,” says Papanikolaou. After all, which companies are more vulnerable to new, ground-breaking advancements—the kind that can shake an industry to its core? Burdened with existing real estate, supply chains, and human capital, value firms are perceived by investors as less able to capitalize on new advantages and more likely to be hurt by them.

Consider a company like Blockbuster circa the mid-1990s—squarely in the “value” camp in that, as Papanikolaou puts it, “everyone had a VCR. We’re all watching movies at home. There wasn’t a lot of room for growth.” When faster in-home delivery and streaming arrived, Blockbuster failed to adapt to the new technologies, and other firms like Netflix and Amazon Prime swept in to steal their market share. “Blockbuster's refusal to adapt made their business model very risky from an investor’s perspective,” says Papanikolaou. “Why would you bother driving to Blockbuster to buy something there and pay the markup?”

Investors aren’t crazy to prefer growth firms, in other words. They prefer growth firms because, in the event “the next big thing” happens, growth opportunities could offset the increased uncertainty about their future prospects that is typically associated with the arrival of new technologies.